Business For Sale Valuations Gone Wild

I have always tried to avoid generalities and instead draw conclusions based upon facts and data. So I am always conflicted by trends - are they really quantifiable, or just a recent turn of events? However, I am going to stray a bit from my usual rules to discuss a situation I see happening more frequently of late in the business for sale arena which is the incredibly creative posturing and thought process that some sellers are using to justify their asking prices.

One of the most important aspects to the business for sale process that allows buyers to complete a deal, is for them to fundamentally believe that the business will transition well to their ownership. The vast majority of small businesses are owner-operated, and thus the assumption is made that the buyer shall take over the seller's role. It is also the reason why small businesses must be valued based upon historical financial data (except in very rare cases), because there is no guarantee that the business will remain status quo from day one after the transition. This is often due to the seller being the main "asset" of the business.

While buyers certainly want to be confident that the business has growth potential, their bigger crieria is to be certain the business can sustain a change of ownership.

In large businesses, where there is a broad infrastructure in place, there is far greater assurances that the business shall stay on course after an acquisition and therefore, it is justifiable to weigh future earnings into the valuation.

However, as a result of the recent downturn where many businesses are experiencing declining sales and profits, we are seeing an usually high number of scenarios where the sellers are basing their valuations on some very aggressive assumptions about the future, and pitching buyers on a lot of "blue sky" theory. While this is certainly an interesting and creative strategy, it's nonsense.

Sellers cannot justify an inflated asking price on the concept of future initiatives a buyer may take to increase the business. How on earth can a seller be entitled to any growth that is strictly the result of a buyer's endeavors? Furthermore, what proof can they possibly have any of these concepts will even work? Lastly, who are they to tell the buyers how to run the business?

As an example, for a seller to believe they should be paid a premium on the business by telling a buyer they only need to hire more salespeople, or attend trade shows, or add new products and services, etc., is a completely illogical argument to attempt to bolster the present-day value of the business. After all, if these initiatives are so simple, why hasn't the seller done them? I reviewed one situation recently where the seller inflated/adjusted his Gross Margins and bolstered the asking price based upon his theory that "a new buyer can get the costs down"...oh yeah, how? And why hasn't the seller been able to do so in the five years he has owned the business?

Another recent  example was a seller of an events marketing company making $150,000 in Owner Benefits who priced his business at $600,000. For years, the company has staged four large events each year with similar profits. The seller believed that any buyer could easily double the number of venues and would then make $300,000 and so the $600,000 was a "very reasonable price" according to the seller. That is complete craziness! To reiterate, I hate generalities, but I have seen at least a dozen similar cases of this ass-backwards strategy for arriving at an asking price over the last month or so.

I guess it's simply a case of when they going gets tough, some sellers get ridiculous.

Now, I do not want to confuse earnouts or performance based deal structures with this delusional valuation ideology. Earnouts are for specific circumstances I have discussed before (i.e. declining business where the buyer needs protection, programs the seller has implemented which will only produce results post-sale, the recent addition or loss of a major customer or supplier, etc) and they have their place, and they are based upon rational thinking.

A small business is sold upon the past historical data. As in most cases, the amount of goodwill represents the largest part of the price, and this is the premium that sellers get for selling an ongoing business. They are not entitled to a "bonus" for the hard work and business acumen that any buyer brings to the business.

When you come across a seller who may be taking this tactic, if you are unable to convince them of their polluted thought process, suggest that they put these so-called "no-brainer" initiatives into place over the next year and if they lead to the results they claim, then they can justify a purchase price inclusive of those results.

Buyers have to be wary of being suckered into this type of pricing model. Remember, it is profit not promises that pay the bills. It is easy to visualize all the wonderful things you can do to the business after you take it over. But keep in mind that if these strategies were so simple, the seller would likely have them in place already (besides, they probably tried some of them and they didn't work). Forget about all the wonderful things a seller tells you that can be done with the business. Instead, focus upon your ability to takeover the business, sustain the present levels, learn it until the business is in your gut, and then put plans into place for growth. With that strategy in mind, clearly, the prior owner has absolutely no right to benefit from your success nor should they have the audacity to think they deserve to be paid in advance for the business skills you have that they clearly lacked.

I welcome your comments and appreciate your feedback. Please feel free to provide your input on this blog. As always, please visit our website if you have any questions about buying a business.

Have a great week.

Comments

[Brad Welborn, CCIM]

Richard,

Again, an excellent article. As I always say, "Potential belongs to the buyer".

[Leon Parker]

We are seeing more of the same foolishness, but there is nothing new about it.

I usually respond to such discussions with sellers by saying buyers will not usually buy a business that doesn't have potential, but that they won't and shouldn't pay for it.

That has cost me some listings, but that is not a problem, because they would have been a waste of time and effort.

[Bashir Manji]

Richard-
You are right on...have been looking at purchasing a small biz for sometime now and keep running into this "over-inflating" and justification for price all the time.
Bashir

[Mark Trail]

As usual Richard, I agree with the comments in your article. I enjoy your weekly articles and seem to regularly experience the same situations in my business that you express in these articles. It's always nice to know that others are going through the same thing - and it causes the same head-scratching.

[businesses for sale]

great post!

[Business Opportunities]

Thanks for sharing this informative article. Good written post.

[Raj]

We are in a process of buying a business and I can assure you the same sales tactics being played on me by the business broker. He goes like this.. The seller is tired and he has not maintained the place.. you can easily make it look better and then it will start to run... If it was that simple seller would have done it in the first place. Thanks for posting another very useful article.